Chapter 2
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Chapter 2A Further Look at Financial Statements
Explain the meaning of generally accepted accounting principles and describe the basic objective of financial reporting.
Discuss the qualitative characteristics of accounting information.
Identify two constraints in accounting.Identify the sections of a classified balance
sheet.
After studying Chapter 2, you should be able to:
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Identify and compute ratios for analyzing a company's profitability.
Explain the relationship between a retained earnings statement and a statement of stockholders' equity.
Identify and compute ratios for analyzing a company's liquidity and solvency using a balance sheet.
Identify and compute ratios for analyzing a company’s liquidity and solvency using a statement of cash flows.
Chapter 2A Further Look at Financial Statements
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General Guide for Financial Accounting
GenerallyAcceptedAccountingPrinciples
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What is financial accounting supposed to accomplish?Provide the the most useful financial information for…
Decision Making
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Primary Accounting Setting Body in the U.S.
FinancialAccountingStandardsBoard
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U.S. Government Agency That Oversees Financial Markets
SecuritiesExchangeCommission
Remember…
GAAP Are the Rules
The FASB makes the rules.
The SEC enforces the rules.
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Basic Terms Relevance - information makes a difference
in decisions Reliability - information must be free of
error and bias Comparability - ability to compare
information of different companies because they use the same accounting principles
Consistency - use of same accounting principles and methods from year to year within the same company
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Characteristics of Useful Information
Relevance
1. Provides a basis for forecasts
2.Confirms/corrects prior expectations
3. Is timely
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Reliability
1. Is verifiable
2. Is a faithful representation
3. Is neutral
Comparability
Different companies use similar accounting PRINCIPLES
Consistency
Company uses same accounting METHODS from year to year
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Constraints in Accounting
Permits companies to apply GAAP without hurting the usefulness of information
Materiality - The constraint of determining whether an item is large enough to likely influence a decision.
Conservatism - The approach of choosing an accounting method, when in doubt, that will be least likely to overstate assets and net income.
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A Classified Balance Sheet... Generally contains the following
standard classifications: Current Assets Long-Term Investments Property, Plant, and Equipment Intangible Assets Current Liabilities Long-Term Liabilities Stockholders' Equity
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Current AssetsAssets that are expected to be converted to cash or used in
the business within one year. Current assets are listed in order of liquidity.Examples:
Cash Short-term investments Receivables Inventories Supplies Prepaid expenses
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Long-Term InvestmentsAssets that can be converted into cash, but
whose conversion is not expected within one year.
Assets not intended for use within the business.
Example: Investments of stocks and bonds of
other corporations. Investments in long-term assets
such as land or buildings that are not currently being used in the company’s operating activities.
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Property, Plant, and EquipmentAssets with relatively long
useful lives.Assets used in operating
the business.Examples:
land buildings machinery delivery equipment furniture and fixtures
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Depreciation is...
Practice of allocating an asset’s full purchase price to a number of years instead of expensing full cost in year of purchase.
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Accumulated Depreciation...
Shows the total amount of depreciation taken over the life of the asset.
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Assets That A Company Depreciates...
Should be shown at cost less accumulated depreciation
CSU CORPORATION Balance Sheet
December 31, 2004
AssetsCash $ 2,000Accounts receivable 4,000Supplies 1,800Equipment 24,000 Less: Accumulated Depreciation 8,000 16,000Total assets $23,800
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Intangible Assets have valuebecause of the exclusive
rights or privileges they possess.
Intangible AssetsNoncurrent assetsHave no physical substanceExamples:
patents copyrights trademarks or trade names franchise
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Current LiabilitiesObligations that are supposed to be
paid within the coming year...accounts payablewages payablebank loans payableinterest payabletaxes payablecurrent maturities of
long-term bankloans payable
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Long-Term Liabilities
Debts expected to be paid after one yearExamples… bonds payable mortgages payable long-term notes payable lease liabilities and obligations under employee pension plans
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Stockholders' Equity
Capital stock - investments in the business by the stockholders
Retained earnings - earnings kept for use in the business
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HUMANA CORPORATIONBalance Sheet
December 31, 200X
(in millions)AssetsCurrent Assets
Cash $ 272Marketable securities (current) 609Receivables 74Other current assets 83
Total current assets 1,038Property and equipment (net) 317
Marketable securities (long-term) 322 Other long-term assets 280Total Assets $1,957 Liabilities and Stockholders’ Equity Liabilities
Current LiabilitiesMedical costs payable $ 527
Accounts payable 233Income taxes payable 56
Total current liabilities 816Long-term debt 83
Total liabilities 899Stockholders’ equity
Common stock 830Retained earnings 228
Total Liabilities and stockholders’ equity $1,957
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Ratio Analysis...Expresses relationship among
selected items of financial statement data
Relationship can be expressed in term of…percentagerateproportion
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Ratio Analysis Classifications...Liquidity Ratios - measures of short-
term ability of the company to pay its maturing obligations and to meet unexpected needs for cash
Profitability Ratios - Measures of the income or operating success of a company for a given period of time
Solvency Ratios - Measures of the ability of the company to survive over a long period of time
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Ratio Analysis Intracompany comparisons - covering
two years of the same company
Industry average comparisons - based on average ratios for a particular industry
Intercompany comparisons - based on comparisons with a competitor in the same industry
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Profitability Ratios...
Measures of the income or operating success of a company for a given
period of time Two Examples… Earnings Per Share Price-Earnings Ratio
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Earnings Per Share
How does the company’s earning performance compare with that of previous years?
Higher value = improved performance
Net income-Preferred stock dividends Average common shares outstanding
EPS=
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Price-Earnings Ratio
How does the market perceive the company’s prospect for future earnings?
High ratio suggests market has favorable expectations
Price-Earnings Ratio = Stock price per share
Earnings per share
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Statement of Retained Earnings
Describes the events that caused changes in the retained earnings account for the period.
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CSU CORPORATIONRetained Earnings Statement
For the Year Ended December 31, 200X
Retained earnings, January 1 $ 0Add: Net Income 6,800 6,800Less: Dividends 0Retained earnings, December 31 $ 6,800
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Statement of Retained Earnings and Statement of Stockholders
Equity
Stockholders’ Equity:Retained EarningCommon StockSince both of these parts affect
stockholders’ equity…a statement of stockholders’ equity
provides better information than a statement of retained earnings.
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Financial Ratio ClassificationsLiquidity Ratios - measures of short-term
ability of the company to pay its maturing obligations and to meet unexpected needs for cash
Profitability Ratios -measures of the income or operating success of a company for a given period of time
Solvency Ratios - measures of the ability of a company to survive over a long period of time
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Liquidity Ratios
Working capital
Current ratio
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Working Capital
Measures short-term ability
to pay liabilities
Current Assets - Current Liabilities = Working Capital
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Current Ratio
Measure of short - term ability to pay obligations
Current Ratio =Current AssetsCurrent Liabilities
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Solvency Ratio
Debt to Total Assets Ratio measures % of assets financed by creditors.
Total DebtsTotal Assets
Debt to Total Asset Ratio =
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Purpose of Statement Of Cash Flows
To provide information about cash receiptscash paymentsnet changes in cash
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Changes Result From
Operating activitiesFinancing activitiesInvesting activities
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Operating Activities
Cash inflows and cash outflows associated with the primary operations of the business.
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Financing Activities
Cash inflows/ outflows come from sources funding the business…
Sale of Stock/ Payment of Dividends
Issuing Debt/Repaying Debt
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Investing Activities
Cash inflows/ outflows result from changes in investments and long-term assets…
purchasing/disposing of investments and long-lived assets using cash
lending money and collecting the loans